Debt - 5 Facts to Help Solve It
Updated: Nov 4, 2021
Our forefathers were profoundly mistaken when they said ‘Money makes the world go around’. In spite of the fact that the lifeblood of all established institution and therefore, society itself is money, the fact remains that credit has been running circles around snail-paced money since conception owing to one major factor, you need to have money to spend money. Contrary to the most common belief in finance, Money is what one uses when credit runs out.
Bankruptcy isn’t contingent on the fact that a person or institution is unable to pay its obligation but on the inability to procure credit. In our capitalist society, it would be apt to say one has lost everything if they lose their credit.
Debt is certainly not evil as it puts a roof over the heads that need it, provides heat to the cold and freezing, heals the ailing and feeds the starving. However an all important lesson when dealing with credit is that in the wrong or incompetent hands, debt is the death of us.
For Debt is an all powerful tool, maintaining control with an ‘obligation to pay’ that needs no army or administration to safeguard it. All that is owed shall be repaid, in one form or another.
In the following article we shall delve through the unique world of debt, where its one’s liability and another’s asset, and highlight some of the features that make it all the more interesting.
Table of Content:-
3. Conclusion
INTRODUCTION TO DEBT
Debt in the essence of the word is an obligation to repay the lender at a specified time with a possibility of paying interest on the amount borrowed by the borrower.
It is a common staple of individuals, corporations and even the Government to make large purchases for which they lack the income or capital at the time being. The most standardised form of debt is known as a loan, which in-turn has many forms such as mortgages, auto loans, credit card borrowings, etc.
The types of debt varies on the type of borrowers, ability to repay debt, term of maturity, recurrence of borrowing, security of debt and the reason behind borrowing. It can be classified as follows:-
1. Consumer Debt, Corporate Debt and Public Debt:
Consumer Debt is the borrowing incurred for the consumption needs of the individuals and are generally in the form of loans or mortgages.
The obligation to repay the debt lies with the individual borrower. The Consumer Leverage Ratio or Debt to Income Ratio gauges the ability of an individual to incur further debt obligations.
Corporate Debt is the borrowing incurred in order to generate funds for a business or invest in it. Corporations generally borrow money in order to avoid further liquidation of equities.
In comparison to Consumer Debt, there are more methods to raise corporate debts such as Commercial Paper and Bonds, all of which can be purchased by Individuals, corporates and even the government as investments that reap interest.
Bonds can be classified on the basis of Maturities, which can be short term (less than three years), medium term (four to 10 years), or long term (more than 10 years). Higher interest rates are offered on longer term bonds since they involve a higher level of risk. The bonds and the corporations themselves are rated on the level of risk involved in the repayment and are classified on the 'quality' of each bond.
Public Debt is the borrowing incurred by the government to finance government spending and fill the deficit in the budgets established by the government to facilitate administrative and financial tasks.
The Debt to GDP ratio is a strong indicator of whether the Government will be able to repay its existing debt obligation and/or raise further debts.
Debt that can improve your current financial standing/standard of living or supplement the income of the borrower is known as Good debt or Positive Debt.
Ex: loan acquired to fund college education, purchase real estate or invest in one's business, etc.
Bad debt or Negative Debt refer to the debt that in no way improve current financial standing of the borrower and in turn further increase their liability or investing in assets that depreciate in value.
Ex: loan acquired to buy a car, clothes, consumables, etc.
Revolving Credit refers to a debt obligation that can be used over and over again as long as the payments are made regularly. The available credit is determined on the usage and repayment of the loan. Interest chargeable is higher than that of non revolving debt.
Debt acquired for a single time use is known as Non Revolving Debt viz. the debt contract terminates once the amount and interest has been cleared as. examples of this type of debts are auto loans and student loans. The interest charged on these types of loans is comparatively less and there is a credit limit.
4. Secured Vs Unsecured Debt:
A Debt obligation backed by collateral is known as Secured debt. If the borrower absconds on a payment, the lender is considered hedged since the ownership of the collateral lapses onto them. The lender then may recoup the amount lent out through the sale of the collateral. Ex: mortgages offered as collateral to acquire loans.
A debt backed by no collateral is known as Unsecured Debt. The lender in such cases is not available to recoup the lent money since there are no collaterals to hedge their investment. These types of loans carry a larger interest rate since the risk of default is prevalent. Ex: Credit Card Debts.
Interesting Facts About Debt
The world of debt holds it own share of surprises and unique features. Listed below are some facts that are lesser known to the public that may surprise you if not pique your interest at the very least:-
The World’s First Bubble was caused essentially by Debt.
The Tulip mania (1634-1638) was a socio-economic crisis that was fuelled by credit in the form of future contracts for tulip buds, a rare and limited commodity at the time. Future contracts were traded to procure tulip buds in the future at a designated price. The contracts were then sold to others buying into the bandwagon at higher prices.
This inflated the price of the securities as investors purchased tulips like men possessed indicating a ceaseless demand for the product. The average price of the commodity shot through the sky almost independently and with no correlation to the commodity itself, with a single bud selling for more than an annual income of a professional or some houses of the time.
Stages of a Bubble
People were willing to trade everything to hold onto the contracts and many sold luxury houses and small castles to do just that. As is with bubbles, the buck stopped with the crazed investors as they realized they had sold their homes for a mere flower and started a massive sell-off. As the prices crashed, Tulip holders and traders went bankrupt.
Tulip Mania Price Index as the Bubble Burst
As per the views of many, Bitcoin will also bear resemblances to the manner in which the price of the asset is inflated through bandwagon movements and enhancement of public confidence in a seemingly trivial product, which in turn shall create the circumstances for yet another bubble.
The Federal Reserve: Lending itself on the back of its Citizens and the World.
The world looked on as the US Senate passed a $2 Trillion stimulus spending bill. A gargantuan stimulus bill paired up with lower taxes is a proven recipe for disaster. Disaster comes in many form, the former called Deficit. Fiscal deficits are generally satiated through borrowing at the individual level which leads to a vicious cycle of people overshooting their ability to repay, causing an uptick in federal debt.
As per estimations, the U.S. budget deficit could soar to a record $3.8 trillion in the fiscal year, which equals a whopping 18.7 percent of the country’s GDP. However the true uniqueness of the system lies in the manner in which the US government and the Federal Reserve generate this debt.
The Fed raises its money through the issuance of debt securities in the form of bonds. The American government essentially borrows from itself and has a long list of individuals, institutions, businesses and governments looking for a safe place to park their investments. The foreign governments are a major contributor to the raising of debt with japan and China leading the board.
The process of Fractional Reserve Banking System through which the US government injects money into its economy is one that baffles most. The Government starts out by initiating a request to the Federal reserve for money, prompting the Federal reserve to purchase Government debt in the form of bonds which are not pegged against any collateral such as Gold.
The Treasury bonds are bought out by the Federal Reserve, who in turn create Federal Reserve Notes known as the US Dollar and peg them against the bonds. On completing this exchange, the new currency is deposited into a commercial bank account which would then become a part of the commercial bank's reserve and legal tender.
On observing this practise, it can be concluded that the US Government essentially lent itself the money. The new money steals value from existing currency in circulation since supply of currency is increased irrespective of the demand for it, reducing the overall purchasing power of the currency, also known as inflation. It can thus be concluded that the fractional reserve banking system is inflationary in nature.
Assuming that the banks are only required to keep 10% of the total reserves as Legal Reserve Ratio the commercial bank will still be able to create credit 9 times in addition to the initial newly injected currency. All the credit created is generally owed by individuals and corporations, thus creating the obligation of repaying the liability which was borne out of debt itself.
The economy at large is financed by debt, indicating that at some point or the other someone has to be indebted to another. For if all loans were repaid, there would be no currency in circulation.
Even though the federal debt is at its highest at $23.7 trillion, the bigger question on everyone’s mind is whether additional borrowing is possible.
Pandemic Era: Debt to GDP Ratio On The Rise
As is with individuals and corporations, The Government too gauges its ability to borrow over and above its existing debt liabilities. The Government upholds this practise through the tabulation of the Debt-GDP Ratio, viz. computing existing loan repayments and comparing it with the income to stipulate whether interest payment on further borrowing will be possible or not.
Japan leads the board as the most leveraged economy with debt level at 266.18% of its GDP and is adding nearly $2 trillion to its existing debt to counter the impact of coronavirus.
Performance of Advanced, Emerging and Developing Economies
Represented on the table above are the follows:-
Red- Advanced Economies,
Blue- Emerging Market and Middle-Income Economies,
Yellow- Low-Income Developing Countries.
Source: imf.org
According to the IMF, Germany and China are among the countries better prepared to stomach the additional spending made necessary to keep their economies afloat. Germany in particular has been widely criticised for its austerity in recent years, taking pride in reaching “the black zero”, i.e. a balanced budget for several years.
Germany is the largest economy with a fair performance with the current standing at 51.1%. Germany has repealed its widely criticized for ‘Schwarze null’ or Black Zero rule which insisted upon fiscal spending to be balanced with tax receipts in order to minimize debt for the foreseeable future.
Global Debt-to-GDP Ratio
Source: imf.org
China’s performance has been commendable as their debt to GDP ratio is increased to 66.53% from 61.7%. Considering the country is the largest economy and the most populated, economists at IMF aren’t concerned with their performance and consider it to be relatively low. Russia(18.94%) is considered one of the lowest percentage of a first world economy.
America’s debt to GDP ratio is as high as it was during the era of World War 2 at a staggering 108%. However, US isn’t the only country to be suffering, for instance, Greece, Italy, Portugal, Belgium and France have the largest Debt to GDP ratio in the European Union.
Case Study: Japan's Shift from Quantitative Freezing to Easing- Twice the debt, Half the Obligation
Japan’s performance troubles started with the stock market crash and real estate bubble burst which put the Government in a position to bail out the banks and insurance companies and provide them with low credit debt. Post bailout, the banks were nationalized and consolidated and fiscal stimulus packages were introduced.
As stimulus packages were introduced, the issue with Japans’ demographic, specifically the rise of ageing or aged population further pressed on social security and healthcare. This lead to Japan Breaching the 100% Debt to GDP mark by the end of 1990s.
To top off a deteriorating situation, Nuclear power plants breakdowns have put a strain on the economy and energy sector.
Natural disasters such as Earthquakes have devastated the country with renovations and relief packages adding to their misery. The cancellation of Olympics which was supposed to boost the country’s economy and tourism was the final nail in the coffin as the country sunk large investments in construction and other avenues.
Japan's 10 Years Debt-to-GDP Ratio
Source: tradingeconomics.com
While a quicker way to reduce the fiscal deficit would be to increase taxes or reduction in public expenditure, it poses a high risk of throttling growth in an already afflicted economy with recessionary tendencies. Therefore in order to finance the stimulant package, Japan issued bonds called JGBs that were snatched up by the Bank of Japan in co-operation with the Government to implement the economic policy effectively.
The Bank of Japan repealed its self-imposed limit on buying JGBs, granting itself limitless power to make purchases. Presently, BoJ holds over half of JGBs. These purchases support the price of the JGBs in the market and inversely lower bond yields, making it sustainable and relatively stable.
Japan's Government Bond Yield
Source: tradingeconomics.com
The ultra-low rate conditions established through the implementation of monetary policy by BoJ is the reason why Japan’s high debt is not as problematic as it is for other high-debt countries. Private and Institutional investors that were burned due to the stock market bubble also see JGBs as a lucrative and safe bet to invest.
Banks, insurance companies and pension funds are limited to invest and lend domestically, therefore JGBs are considered as a safe haven. A substantial segment of wealth is held by risk averse ‘seniors’ that are deprived of financial literacy who prefer stability over return.
Inspite of its glaring issues with debt, Japan’s market reputation hasn’t taken a dive since its one of the biggest lender to the rest of the world, with more than $3 trillion in foreign currency holding and foreign direct investment. However, the debt repayments account for the country’s second largest budgetary commitment.
Case Study: Greece Debt Crisis
As is the case with deficit, it certainly spelled doom for Greece. Greece entered the European Union as its 10th member back in January of 1981, sporting a robust financial system with minimal deficit and a relatively low Debt-to-GDP Ratio. However the next 30 years lead to a sharp decline in the standards of fiscal policy implemented in the country.
In a ploy to keep power, political parties lavished the public with welfare policies and benefits which included a salary hike for government employees every year irrespective of their performance, the price of which they had no means of paying. This resulted in an overly leveraged economy that was inflating itself on the back of debt.
To top it all off the Government introduced a scheme which entitled employees to a 14-month salary structure inspite of working only 12 months constituting the year. All this burdened the economy and deepened the deficit, a gap the economy had no means of recovering owing to a decline in productivity and large number of tax evaders.
The Greek Government realised that the vicious cycle they created could only be satiated through further borrowing, and thus they adopted Euro in 2001 to make borrowing from other EU countries easier. Government Bonds prices and value in the country fell sharply since they were competing with bonds of other European Countries such as Germany.
Greece's Government Bond Yield
Source: tradingeconomics.com
The Bonds were quick to be taken up since the growth in the country's GDP led investors to believe it was a sound alternate investment in comparison to the highly valued German Bonds. Greece managed to go from a negligible Debt-to-GDP ratio of 28% to one overshooting the prescribed norms of EU at a shocking 103%. The country may have gotten away with had it not been for the 2008 financial crisis.
With delinquencies on the rise debt collection became a critical concern for lenders and countries were no exceptions. Greece's Creditors increased interest rates as compensation for risks involved in lending out money. The increased liability proved too much in the subsequent years, leading to a further decline in bond value.
The economy contracted and in 2014, the Government decided to come clean about their predicament, indicating that they had been lowballing the fiscal deficit and boosting their economic performance. Investors rallied for return on their loans however Greece had nothing much to give to begin with.
A Breakdown of Greece's Debt
Source: money.cnn.com
By 2015, The country was plunged into debt with no way out and began missing out on payments to their creditors including the International Monetary Fund(IMF). A first in history, a country defaulted in paying a whopping 1.6 Billion euros to the IMF. With low to none revenue, Greece resorted to fund itself through debt which proved disastrous.
The countries bailouts were intended to only pay the creditors and hung the public out to dry and reel from the shock of living in a country with no revenue struggling to provide the basic welfare to its citizen.
CDOs still exist!
While it may seem Collateralized debt obligations (CDOs), the leading cause of the financial crisis of 2008, are returning; the fact of the matter is that it never left in the first place. A quick lesson in CDOs if you haven’t heard of them inspite of everything:
They are the types of security born out of existing debt securities such as mortgage-backed securities and corporate bonds. These debts are clubbed together and divvied up in segments or tranches of varying levels of risk and returns before being available to investors. The money paid to the investors is through the repayment of someone else’s debt obligation.
CDOs are popular since they pay more than T-Bills and are lucrative to institutional investors. As depicted in Michael Lewis' The Big Short, CDOs are notorious for their job in monetizing the subprime mortgage crisis that snowballed into the 2008 financial crisis. Warren Buffet even went as far to call CDOs and other derivatives "financial weapons of mass destruction" a long time before the financial debacle.
Since the value of CDOs are pegged on that of the underlying securities, CDO holders missed out on expected payments when mortgage holders defaulted en-masse a.k.a. the mortgage crash of 2008, adding fuel to fire and pretty much burning the world economy to a crisp which the world now knows as The Great Recession. Banks that were over leveraged on the sub-par debt obligations started to default themselves, for example, failed financial giant Lehman Brothers and Bear Stearns
Although CDOs played a leading role in the Great Recession, they were not the only cause of the disruption, nor were they the only exotic financial instrument being used at the time. CDOs are risky by design, and the decline in value of their underlying commodities, mainly mortgages, resulted in significant losses for many during the financial crisis. CDOs proliferated throughout what is sometimes called the shadow banking community.
Shadow banks facilitate the creation of credit across the global financial system however members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions. Hedge funds, unlisted derivatives, and other unlisted instruments are intermediaries not subject to regulation.
Credit default swaps are examples of unregulated activities by regulated institutions.
As the practice of merging assets and splitting the risks they represented grew and flourished, the economics of CDOs became ever more elaborate and rarefied.
CDOs and CLOs (collateralised loan obligations) are not going to go away since they are powerful risk management devices in principle. With the Federal Reserve committed to keeping interest rates low, investors — such as pension funds seeking higher returns — are driving demand once again for these structured securities, which are riskier but provide more bang for the buck than safer bets such as Treasuries and investment-grade corporate bonds.
Source: ft.com
The net size of the market for tranches of synthetic collateralized debt obligations linked to credit indices has increased to a four-year high of US$141bn, according to the DTCC. That comes amid a flurry of trading, with volumes of tranched credit-default swap indices rising 45% annually in the first half of the year to US$96bn, according to IHS Markit.
It is the advice of most economist and financial advisors that CDOs must go through a clearinghouse as the presence of an intermediary improves transparency. However, in order for that to occur, CDO contracts will have to undergo standardization otherwise only a small percentage will go through clearinghouses.
Consumer Debt on the Rise while Delinquencies Fall
Consumer Debt is on an all time high at $14.6 trillion owing to increase in mortgages, which has crossed the $10 trillion mark. This marks a shift from the rising auto loans and student loans to more conservative issuance of fresh mortgages in order to fund moving from cities to suburban areas, new investment projects or to consolidate debt.
Source: ft.com
The American President, Joe Biden, recently proposed a $10,000 waive off per person from the federal student loans and paused the collection of instalments for the same during the coronavirus Pandemic. This is nothing short of a boon as indicated by falling delinquency rates. However, many students are left disheartened as they pushed for a waiver of upto 50,000$ per person.
The same missed out on the fact that most defaults of student loans occur when the amount owed is less than $10,000, nearly two-thirds of it. Delinquencies, especially on student loans comes at a great cost as certain states have gone so far as to revoking drivers license. In the past, entry-level professionals even lost a percentage of their wages to federally backed lenders when their payout did not cut it.
While the payment pause or forbearence is certainly welcome student loans account for the highest payable instalments for most Americans, the gargantuan principal amount excluded, the debate of waiving off student loans is one of ethics rather than a mere financial decision as citizens have worked extremely hard to pay off debts completely and many have not gone to colleges or universities due to the exorbitant price tag.
Source: ft.com
The fall in delinquencies is good news for consumers as non repayment of debt is a serious issue that afflicts the borrower till the end of time. Apart from escaping the relentless calls of debt collectors and a hit to the credit score, consumers are safe from even bigger dangers that non-repayment of debt represents such as issuance of new credit. One's existing borrowings are considered case of applying for a mortgage, majority of which are to be passed up if monthly instalments exceed 40%.
Conclusion
When it comes to debt all bets are off owing to one factor, some are just more debt savvy than the rest. The mechanism of debt is a powerful tool in the hands of those that can utilise it efficiently and a recipe for disaster for those who don't. It is quintessential to realise that debt shall not be raised by those who can't repay it, for even countries topple when it is time to repay one's obligation.
Risks in debt should always be minimised and contingencies must be made in order to avoid delinquencies. While debt consolidation seems to be a good way of postponing non repayments on a loan, it can eventually increase your burden when instalments on the newly acquired loans are due and are feasible for only that section of borrowers who have exceptional creditworthiness. Such practices may lead to a debt trap unless the debtor only borrows the money that they can repay as debt essentially is equivalent to borrowing from one's future income.
It is therefore quintessential to assess solvency and ability to take and repay additional debt as precisely as possible with a conservative outlook towards future income.Another takeaway from the aforementioned points is to prioritise the accumulation of good debt over bad debt. Debt utilised to create new assets fundamentally pays for itself. However the soundness of the investment is just as important since investing low yielding or fraudulent securities will be catastrophic.
Financial Discipline is an absolute when it comes to debt finance. With the number of kids debit cards for learning about money available today, financial discipline can be instilled from an early age. Debt financing puts a significant load on one's future cashflow and therefore should only be used up till a certain point. As a rule of thumb, one should stay away from high interest debt as they end up paying a whole lot more than the value of their purchase.
